Hello, volatility

By John Spence

An exchange-traded note following the VIX saw its two highest trading days ever on Thursday and Friday amid the stock sell-off.

The iPath S&P 500 VIX Short-Term Futures ETN (VXX) gained 5.4% on Thursday, then rose an additional 8.8% on Friday. The Dow lost more than 200 points on both days. Investors are clearly worried about a correction after the big run-up since March. Obama is talking tougher on financial regulation. Bernanke is under the microscope. Questions on China and rates. The list goes on.

The iPath S&P 500 VIX Short-Term Futures ETN is only about a year old, but has assets of more than $1 billion. It traded over 11 million shares on both Thursday and Friday. Before that, it had never broken through 8 million shares, according to data from FactSet Research.

They’re designed to track VIX futures contracts, not the spot price. Why is this important? Because the VIX (its proper name is the CBOE Volatility Index) rose 19.2% on Thursday and 22.6% on Friday. The ETN fell well short of that.

Bradley Kay at Morningstar explains the nuances in his latest analyst report on the ETN.

“Because many institutions use [VIX] futures to guard against adverse market movements, the prices of longer-dated contracts include sizable insurance premiums that disappear as they move toward expiration,” Kay writes.

“This produces a large negative roll yield, so this ETN will lose money during periods of market stability and constant volatility,” the analyst says. “Furthermore, these futures contracts do not fully participate in spikes in the spot VIX because they proxy for expected future volatility, which will always be higher during periods of low present volatility and lower during periods of high present volatility due to the asset class’ well-known mean-reversion.”

The iPath S&P 500 VIX Short-Term Futures ETN was down about 3% in early trading Monday as stocks regained some of their losses to start the week.